ABC Analysis: A Critical Inventory Management Tool

ABC Analysis is a method of tiered inventory or supplier valuation that
divides inventory/suppliers into categories based on cost per unit and
quantity held in stock or turned over a period of time. This is one of
the four methods of overall materials management and inventory
management.

ABC analysis can often be confused with Activity Based Costing, a
similar sounding term that refers to a method of manufacturing costing
that is more refined than the traditional machine-hours method of
determining the overhead cost of a finished product.

What is the Purpose of ABC Analysis?

ABC Analysis allows inventory/purchasing managers to segregate and
manage the overall inventory/suppliers into three major groups. This
allows different inventory/supplier management techniques to be applied
to different segments of the inventory/suppliers in order to increase
revenue and decrease costs. In terms of a Pareto Analysis, it separated
the critical few from the trivial many.

"A" Category items generally represent approximately
15%-20% of an overall inventory by item, but represent 80% of value of
an inventory. By paying attention close attention in real-time to the
optimization of these items in inventory, a great positive impact is
possible with minimal increase in inventory management costs.

"B" Category items represent 30%-35% of inventory items
by item type, and about 15% of the value. These items can generally be
managed through period inventory and should be managed with a formal
inventory system.

"C" Category items represent 50% of actual items but
only 5% of the inventory value. Most organizations can afford a
relatively relaxed inventory process surrounding these items.

How to Do an ABC Analysis?

There are six basic steps1.

Identify the objective for the analysis. Determine success criteria.
An ABC analysis can accomplish one of two primary goals: to reduce
procurement costs or to increase cash flow by having the right items
available for production or direct to customer sales.

Collect data on the inventory under analysis.
The most common data, generally available from standard accounting
already in place, is annual spend per item. This can be in terms of raw
purchase dollars, or weighted cost including all ordering costs and
carrying costs, if those can be readily calculated.

Sort inventory in decreasing order of impact.
From most to least, rank order each inventory item by cost.

Calculate accumulated impact.
Using a spreadsheet tool, calculate the cumulative impact of the list of
inventory items by dividing item annual cost by total inventory annual
spend, then adding that amount to the cumulative total of percentage
spent.

Divide inventory into buy classes.
This may not be a precise 80/20 characterization. Take a holistic view and do not concern yourself with an exact 80/20 rule.
The goal is to find areas where renegotiating contracts, consolidating vendors, changing strategic sourcing methodology, or implementing e procurement may deliver significant savings or ensure in-stock availability of high-volume items.

Analyze classes and make appropriate decisions.
The key to this step is follow-up and tracking. Once strategic cost management is in place based on categories, periodic review is critical to monitoring the success or failure of the decisions.

Conclusion

ABC analysis is a valuable tool to enable companies
dedicated to strategic cost management to measure the current status for
their materials management system and look for the "low hanging fruit",
the simple changes that can yield the largest cost management benefits
in the near and middle term periods.